Red flags revealed in filings of firm linked to Caterpillar fraud

January 24, 2013|Reuters

A Caterpillar bulldozer sits on a rail car outside the Caterpillar plant in Peoria. (Frank Polich/Reuters)

A Chinese mining equipment company at the centre of an alleged accounting fraud was also involved in a web of insider loans and asset transfers prior to its purchase by Caterpillar Inc., public filings show.

The transactions, while not illegal, should have sounded warnings about the company's finances when the U.S. firm came calling last year, corporate governance experts said.

The world's largest maker of tractors and excavators said last week it was writing off most of the $654 million value of its purchase of ERA Mining Machinery Ltd. after uncovering "deliberate, multi-year, coordinated accounting misconduct" at its subsidiary Zhengzhou Siwei.

Caterpillar said an internal investigation had uncovered improper accounting of inventories, revenue recognition and cost allocation at Siwei, designed to overstate the profitability of the business in the years before it bought it.

Corporate disclosures from ERA filed prior to the takeover show some unusual transactions, including directors lending the company cash at relatively high interest rates and asset-shuffling between Siwei and related parties.

Investors and corporate governance experts say these were potential red flags that should have prompted Caterpillar and its team of lawyers, accountants and bankers to ask some searching questions before pulling the trigger on the deal.

"Every time there's a horror story like this, it acts as a damn good wake-up call that you need to look carefully before you do a deal," said David Holloway, senior managing director at FTI consulting and an expert in investigation of business fraud.

Caterpillar declined to comment on the ERA directors' loans and did not respond to a request for comment on Siwei's operations. ERA directors could not be reached for comment.

A source directly involved with the Caterpillar deal said RSM Nelson Wheeler was ERA's auditor, while Deloitte and Ernst & Young acted on Caterpillar's side. RSM did not respond to calls and emails and Deloitte and E&Y declined to comment.

One of the directors who lent the company money was Beijing-based U.S. businessman Emory Williams Jr, a former chairman of the American Chamber of Commerce in China and son of a former Sears Bank and Trust Co. chairman and chief executive.

A second was Li Rubo, a graduate of the South Dakota School of Mines and former Chinese government official. There are no allegations of illegality against any of ERA's directors.

A security guard at Siwei's six-storey, glass-fronted headquarters on the outskirts of Zhengzhou, eastern China, stopped a Reuters reporter from entering the campus, saying senior managers were all in Beijing for meetings.

Reuters' efforts to contact ERA chairman Williams, Li and other directors and major shareholders at listed addresses in Hong Kong, Beijing, Shanghai and Zhengzhou and by telephone and email were also unsuccessful.

RED FLAGS

One concern about ERA should have been why the Hong Kong-listed company needed to borrow more than $9.5 million from four directors -- who earned nearly $500,000 in interest -- at loan rates that were among the most expensive on its balance sheet.

"It wouldn't necessarily mean there are cash flow problems but it would be a massive red flag", because it would call into question whether the financing was in the company's best interests, a U.S. lawyer experienced with China transactions, commenting on condition of anonymity, wrote in an email.

The personal loans are detailed in regulatory filings made to the U.S. Securities and Exchange Commission prior to ERA's takeover by Caterpillar in June last year.

"While company loans to directors are a governance no-no, the opposite is more of a grey area," said Jamie Allen, secretary general of the Asian Corporate Governance Association, in an emailed response to a Reuters' question.

"Is the interest rate fair and at arm's length? Why didn't the company go to a bank?" Allen said he had not studied the ERA deal in detail, but these would have been important questions to ask.

David Webb, a shareholder activist and member of the Hong Kong Securities and Futures Commission's Takeover and Mergers Panel, said local listing rules allowed directors to lend money to companies at normal commercial terms, provided the loan was not securitised, although it was not a common practice.

"Presumably the board would have looked at alternative sources of funding," he said.

In one example, in April 2010, Williams and Li lent $6.4 million to pay down loans of nearly $20 million, mostly funded by a U.S. private equity firm, that were used to acquire Siwei, and for working capital, according to the filings.

Williams and Li made the loan at an interest rate of 8 percent per year, compounded annually. In a letter from the board at the time of ERA's reverse merger, the directors, who did not yet include Williams and Li, called the loans "fair and reasonable" and "justifiable".

ERA's loans with commercial banks at the time were at interest rates ranging from 4.9 percent to 7.4 percent.